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Reckless Caution Has Damaged UK Pension Pots

[Marcus Ashworth co-authored this column.]

Trustees of pension funds are not usually in the habit of skinny dipping. However, when the market tide ebbs, Warren Buffett’s infamous “swimming naked” quote applies every bit to them as it does overstretched meme stock and cryptocurrency investors. For the guardians of retirement savings, their over-reliance in recent years on inflation-linked bonds has left them exposed.

These securities, called TIPS in the US and known as linkers in the UK, comprise two elements: a fixed (usually very small) coupon, and a separate floating payment tied to an inflation index. They have become increasingly popular as hedging instruments, widely regarded as the less volatile elements in portfolios vulnerable to swings in equity markets.   

Unfortunately, the hedges have performed worse than the risks they were supposed to counterbalance. Even as inflation has soared to levels not seen for decades —  the very scenario that should mean these hybrid securities outperform regular bonds — the value of the longest-dated index-linked gilts has halved since the start of the year. It has taken barely six months to entirely unwind most of the gains made since 2014. 

One of the greatest risks faced by retirement funds tasked with providing pensions based on final salaries to their members is that rising consumer prices will inflate their liabilities. Payments rise in line with inflation, offering fantastic financial security to current and future retirees, but at enormous expense to employers. That is why such generous arrangements have become increasingly rare over the years in the UK, replaced by money-purchase pots that are the responsibility of the individual and are fully exposed to the whims of the financial markets.

The final-salary pension plans that remain have become increasingly focused on matching assets to liabilities. Government-issued inflation-linked bonds would appear ideal instruments for this purpose, rated at the highest credit quality with returns explicitly linked to the cost of living.  But recent market moves have exposed a fundamental flaw in the strategy. 

Inflation-sensitive funds have piled into linkers in recent years, driving valuations to sky-high levels and emboldening asset managers to load up on riskier investments elsewhere in their seemingly hedged portfolios. As financial markets have shifted dramatically into risk-off mode in recent months, though, unwinding those bets has caused enormous selling pressure, more than offsetting the inflationary backdrop and driving linker values far below their theoretical levels. A lack of supply, leaving too many funds chasing too few of the long-dated bonds they need to pay pensions for decades to come, has exacerbated the problem.

Ultra-long maturity bonds with low coupons are especially sensitive in price terms to shifts in interest-rate expectations. And the surge in long-term yields this year as central bankers have raced to tighten monetary conditions is perceived to make recession more likely, moderating longer-term inflation expectations and reducing the attractiveness of inflation-linked debt as a hedge against future cost-of-living increases.

To be fair to the pensions industry, more aggressive funds have also fallen foul of the imperfections of the inflation-linked market. Many asset managers have attempted to offset large exposures to tech and speculative growth stocks with supposedly defensive, inflation-hedging bonds —  and have ended up losing heavily on both parts of their portfolios. 

By simultaneously piling into the same illusory portfolio hedge, pension funds have ended up recklessly over-exposed to the rapid shifts in fixed-income markets this year. Their herd behavior will inevitably increase the pressure to further reduce benefits and increase employee contributions. One way or another, all of their savers will lose — especially those still a long way from retirement.

More From Bloomberg Opinion:

• UK’s Discontent Risks Deepening the Malaise: Mohamed El-Erian

• A Big Tax Bill Awaits Those Draining Their Pensions Early: Stuart Trow

• Are the Days of UK Property Booms and Busts Over?: Chris Hughes

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Stuart Trow is co-host of “Money, Money, Money” on Switch Radio and author of “The Bluffer’s Guide to Economics.” Previously, he was a strategist at the European Bank for Reconstruction and Development.

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